Image Source: Pixabay

For a long time, I’ve held the opinion that the notion of “anchored inflation expectations” was an absurdity. For one thing, we have no good way to measure inflation expectations: market-based measures don’t reflect consumer expectations, and survey measures are nonsense that mostly reflect an availability bias (i.e., changes in small, frequently-purchased items, especially gasoline, have a much larger impact than large, infrequently-purchased items). There are lots of other biases in inflation perception, some of which I enumerated and discussed in a scholarly-ish article almost a decade ago.

It isn’t that I think that people don’t have inflation expectations, or that they are ‘wrong’ in some sense. It is just that the notion that they are “anchored” is something that is completely unmeasurable and so hypothetical. But many economists believe that hypothesis is necessary to help explain the break-in inflation models around 1992-1993. I think there are better explanations for that break, which don’t require assuming a can opener.

However, recently I have started to reconsider whether there is a way in which behaviors concerning inflation are at least sticky. This is not to say that I think this necessarily has a role in inflation modeling (importantly, because there’s no good way to measure it), but I have definitely seen anecdotally some behaviors that can only be explained by figuring that consumers and producers become at least conditioned to expect low and non-volatile inflation. (Note, if I’m right about it being a conditioned response rather than an anchoring with respect to “strong central bank messaging,” it is useless in explaining the 1992-93 inflation model break because my hypothesis is that it takes a long time to happen).

My thoughts derive from some direct observations I have of actual producer/supplier behavior, from customers of mine and their suppliers, over the last couple of years but especially in response to the latest spike in raw materials prices. When I first began this sort of risk and pricing consulting a few years ago, I was struck at the attitude that one of my customers seemed to have – the customer behaved as if it was a commodity producer facing extremely elastic demand curves, such that they were very convinced that if they raised prices at all, they would lose a huge amount of their business to suppliers in China and India. Their customers of course reinforced this notion by responding to questions about price by saying that “lower prices would be good.”[1] But their product was both higher quality and shorter lead time than that of the competition; yet, they priced it as if only price mattered to their customers. The important point, though, is that they were conditioned to believe that any increase in price would destroy their business.

Their attitude wasn’t unique. Until recently you could see that behavior all over. To a surprising degree, diners with printed menus (with pictures!) have tended in recent years to have prices pretty much hard-coded and printed onto the menu. Your local barber probably changed prices every five years, at most. And every change was usually accompanied by an explanation to the customer about the need for higher prices for one reason or another. It is a strange dynamic, very different from what you see in an inflationary regime, such as in this classic scene from the movie Caddyshack (released in 1980):

Tony D’Annunzio: Give me a Coke.

Danny Noonan: One Coke.

[gives Tony a bottle of Coke and 50 cents]

Tony D’Annunzio: Hey wait a minute. That’s only 50 cents.

Danny Noonan: Yeah, well, Lou raised the price of Coke. He’s been losing at the track.

Tony D’Annunzio: Well I ain’t paying no 50 cents for no Coke.

Danny Noonan: Oh, then you ain’t getting no Coke!

Instead, in this era of low and stable inflation, it looks and feels like suppliers have learned “anchored” behaviors. “I can’t raise prices; all of my customers will leave.”

Fast forward to the COVID crisis.

Input costs for many producers have skyrocketed. For example, the price of polypropylene has roughly tripled since the lows last summer. Yes, at least part of that is temporary. Up until about six months ago, when movements in input costs induced changes in profitability for producers they would hold the line on prices, lest they lose a bunch of business, and watch their margins decline. Ultimately, when input costs retraced, they would enjoy wider margins again. Price changes were artificially muted because the supply chain dampened price fluctuations. The producer absorbed those costs because of the perceived elasticity of end product demand.

However, the volatility of input prices recently has been such that producers couldn’t absorb all of the costs into margin and still remain viable. Some of the suppliers and competitors to the client I mentioned above did indeed hold prices as long as they could, before eventually passing them on with great apologies. I advised my client, though, to pass cost increases through immediately. Some in management wanted to label the increase a “surcharge,” but that again is an apologetic way to adjust prices – and one you do need to justify. Instead, they jacked up their prices to maintain their margins, and braced for the worst.

And lo and behold…nothing happened. Some customers wanted an ‘explanation’ for why the price of the Coke went up, and some customers complained that the Coke was cheaper elsewhere. Ultimately, my client did just as much business after the price increase as they did before the price increase.

What they learned, and what lots of suppliers, restauranteurs, and others are learning, is that demand is not as elastic as they had thought; that everyone wants a lower price but they’ll pay for the value of the product if they need the product. That, with more money in the system, raising prices a little doesn’t hurt business very much at all. If you need a Coke, you’ll pay the fifty cents for a Coke even if you wish it was still forty cents (and part of the reason you will pay without much complaint is because you just got $1,600 from the government for no reason at all).

Watching this behavior is what makes me wonder about the anchoring of inflation expectations. Again, I think of this as a conditioned behavioral response. By the same token, though, people can unlearn these conditioned responses. We are all conditioned now to put on a mask when going into a restaurant, but we will (hopefully) unlearn that behavior, and the new conditioning will be to not put on a mask when entering a restaurant. That’s what’s happening now, I think, to suppliers in many industries. I think they’re all surprised, but I also think they’ll remember. It’s just one of many reasons I think that regardless of the path inflation takes over the next decade, it will likely be both higher on average and more volatile as well. Take away the “anchor” and the ship tosses about more, and moves with the tides. I don’t really know of a good way to model this, and I am also fairly confident that the Fed will not recognize that the anchor has been slipped (which means bad things in expectations-augmented Phillips Curve models!) for a while. To be clear, I don’t think the lack of policy response to the un-anchoring matters much because I don’t think the Fed had very much to do with the conditioning in the first place and expectations won’t become “re-anchored” merely because of the central bank’s messaging. I guess I don’t really think the central bank’s messaging means as much to consumers as they think it does! In any event, it takes time for conditioning to take hold, but less time I think for the conditioning to be broken.

[1] One of my first recommendations was that they stop asking this question. What do you expect customers to say, that they want higher prices? The question is whether they will not buy your product at a higher price, and asking their opinion on that is a really bad way to find out the answer.